A few weeks ago,
a journalist devoted a substantial part of a profile of yours truly to
my failure to pay due attention to the "Austrian theory" of the business
cycle--a theory that I regard as being about as worthy of serious study
as the phlogiston theory of fire. Oh well. But the incident set me thinking--not
so much about that particular theory as about the general worldview behind
it. Call it the overinvestment theory of recessions, or "liquidationism,"
or just call it the "hangover theory." It is the idea that slumps are the
price we pay for booms, that the suffering the economy experiences during
a recession is a necessary punishment for the excesses of the previous
expansion. The hangover theory
is perversely seductive--not because it offers an easy way out, but because
it doesn't. It turns the wiggles on our charts into a morality play, a
tale of hubris and downfall. And it offers adherents the special pleasure
of dispensing painful advice with a clear conscience, secure in the belief
that they are not heartless but merely practicing tough love.

Powerful as these seductions
may be, they must be resisted--for the hangover theory is disastrously
wrongheaded. Recessions are not necessary consequences of booms. They can
and should be fought, not with austerity but with liberality--with policies
that encourage people to spend more, not less. Nor is this merely an academic
argument: The hangover theory can do real harm. Liquidationist views played
an important role in the spread of the Great Depression--with Austrian
theorists such as Friedrich von Hayek and Joseph Schumpeter strenuously
arguing, in the very depths of that depression, against any attempt to
restore "sham" prosperity by expanding credit and the money supply. And
these same views are doing their bit to inhibit recovery in the world's
depressed economies at this very moment. The many variants
of the hangover theory all go something like this: In the beginning, an
investment boom gets out of hand. Maybe excessive money creation or reckless
bank lending drives it, maybe it is simply a matter of irrational exuberance
on the part of entrepreneurs. Whatever the reason, all that investment
leads to the creation of too much capacity--of factories that cannot find
markets, of office buildings that cannot find tenants. Since construction
projects take time to complete, however, the boom can proceed for a while
before its unsoundness becomes apparent. Eventually, however, reality strikes--investors
go bust and investment spending collapses. The result is a slump whose
depth is in proportion to the previous excesses. Moreover, that slump is
part of the necessary healing process: The excess capacity gets worked
off, prices and wages fall from their excessive boom levels, and only then
is the economy ready to recover.

Except for that last
bit about the virtues of recessions, this is not a bad story about investment
cycles. Anyone who has watched the ups and downs of, say, Boston's real
estate market over the past 20 years can tell you that episodes in which
overoptimism and overbuilding are followed by a bleary-eyed morning after
are very much a part of real life. But let's ask a seemingly silly question:
Why should the ups and downs of investment demand lead to ups and downs
in the economy as a whole? Don't say that it's obvious--although investment
cycles clearly are associated with economywide recessions and recoveries
in practice, a theory is supposed to explain observed correlations,
not just assume them. And in fact the key to the Keynesian revolution in
economic thought--a revolution that made hangover theory in general and
Austrian theory in particular as obsolete as epicycles--was John Maynard
Keynes' realization that the crucial question was not why investment
demand sometimes declines, but why such declines cause the whole economy
to slump. Here's the problem:
As a matter of simple arithmetic, total spending in the economy is necessarily
equal to total income (every sale is also a purchase, and vice versa).
So if people decide to spend less on investment goods, doesn't that mean
that they must be deciding to spend more on consumption goods--implying
that an investment slump should always be accompanied by a corresponding
consumption boom? And if so why should there be a rise in unemployment?

Most modern hangover
theorists probably don't even realize this is a problem for their story.
Nor did those supposedly deep Austrian theorists answer the riddle. The
best that von Hayek or Schumpeter could come up with was the vague suggestion
that unemployment was a frictional problem created as the economy transferred
workers from a bloated investment goods sector back to the production of
consumer goods. (Hence their opposition to any attempt to increase demand:
This would leave "part of the work of depression undone," since mass unemployment
was part of the process of "adapting the structure of production.") But
in that case, why doesn't the investment boom--which presumably requires
a transfer of workers in the opposite direction--also generate mass unemployment?
And anyway, this story bears little resemblance to what actually happens
in a recession, when every industry--not just the investment sector--normally
contracts. As is so often the
case in economics (or for that matter in any intellectual endeavor), the
explanation of how recessions can happen, though arrived at only after
an epic intellectual journey, turns out to be extremely simple. A recession
happens when, for whatever reason, a large part of the private sector tries
to increase its cash reserves at the same time. Yet, for all its simplicity,
the insight that a slump is about an excess demand for money makes nonsense
of the whole hangover theory. For if the problem is that collectively people
want to hold more money than there is in circulation, why not simply increase
the supply of money? You may tell me that it's not that simple, that during
the previous boom businessmen made bad investments and banks made bad loans.
Well, fine. Junk the bad investments and write off the bad loans. Why should
this require that perfectly good productive capacity be left idle?

The hangover theory,
then, turns out to be intellectually incoherent; nobody has managed to
explain why bad investments in the past require the unemployment of good
workers in the present. Yet the theory has powerful emotional appeal. Usually
that appeal is strongest for conservatives, who can't stand the thought
that positive action by governments (let alone--horrors!--printing money)
can ever be a good idea. Some libertarians extol the Austrian theory, not
because they have really thought that theory through, but because they
feel the need for some prestigious alternative to the perceived statist
implications of Keynesianism. And some people probably are attracted to
Austrianism because they imagine that it devalues the intellectual pretensions
of economics professors. But moderates and liberals are not immune to the
theory's seductive charms--especially when it gives them a chance to lecture
others on their failings. Few Western commentators
have resisted the temptation to turn Asia's economic woes into an occasion
for moralizing on the region's past sins. How many articles have you read
blaming Japan's current malaise on the excesses of the "bubble economy"
of the 1980s--even though that bubble burst almost a decade ago? How many
editorials have you seen warning that credit expansion in Korea or Malaysia
is a terrible idea, because after all it was excessive credit expansion
that created the problem in the first place? And the Asians--the
Japanese in particular--take such strictures seriously. One often hears
that Japan is adrift because its politicians refuse to make hard choices,
to take on vested interests. The truth is that the Japanese have been remarkably
willing to make hard choices, such as raising taxes sharply in 1997. Indeed,
they are in trouble partly because they insist on making hard choices,
when what the economy really needs is to take the easy way out. The Great
Depression happened largely because policy-makers imagined that austerity
was the way to fight a recession; the not-so-great depression that has
enveloped much of Asia has been worsened by the same instinct. Keynes had
it right: Often, if not always, "it is ideas, not vested interests, that
are dangerous for good or evil."

If you didn't click the link in the article, here's
a quick review of the (misguided) thoughts of von Hayek and Schumpeter.

LinksA libertarian publication called the New Australian
offers a vehement assertion of the superiority of Austrian
business cycle theory over Keynesianism. If you figure out what
the author is saying, let me know. My earlier Slate piece
"Baby-Sitting
the Economy" offered a hangover-free parable that explains how
recessions happen and how they can be cured. An essay by Bradford De Long
about the Great
Depression contains some eye-opening quotes from von Hayek and
Schumpeter. As their contemporary Ralph Hawtrey put it, they were "[c]rying,
'Fire! Fire!' in Noah's flood."

Paul Krugman is a professor of economics
at MIT and the author, most recently, of The Accidental Theorist and
Other Dispatches From the Dismal Science. His home
page contains links to many of his other articles and essays.